8 Critical Charts for the Week Ahead

by Daniel Putnam | May 21, 2012 6:00 am

While the investment world spent Friday afternoon watching Facebook [1](NASDAQ:FB[2]) struggle to close the day above its $38 offering price, the real action was occurring elsewhere. No fewer than five major indices and ETFs fell to key support levels on Friday, while three others moved further into dangerous territory. Whether or not these can hold in the week ahead will go a long way toward telling us if this downturn is a garden-variety correction — or the beginning of something worse.

First, the drop of nearly 9% in the S&P MidCap 400 Index so far this month has caused this measure to fall all the way back to its 200-day moving average. The MidCap 400 closed Friday at 905.28, slightly more than a point above its 200-day of 904.42. This bears watching because the three large-cap indices — the Dow Industrials, S&P 500 and Nasdaq 100 — still have some room to run before they reach their 200-day MAs. A breakdown in the midcap index would increase the odds that large-caps are destined for further pain.

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Along this same line, the chart of the Russell 2000 Index shows an even worse picture. On Friday, the small-cap index broke below its 200-day MA (at 753.20) to close at 747.21. While this is obviously a bearish signal, there’s a bright side: The Russell has fallen so far that it has pierced its lower Bollinger band[4]. For an index, this is an infrequent occurrence that usually happens only about five or six times a year.

Also, the Russell’s relative strength index (RSI) has collapsed to 25.8, its second-lowest level of the past three years. This indicates extremely oversold conditions that would typically precede a bounce, but investors still need to monitor the Russell’s position in relation to its 200-day in the weeks ahead.

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Investors also need to keep an eye on the Select Sector SPDR-Industrial ETF (NYSEARCA:XLI[6]). The other two sector SPDRs with the highest economic sensitivity — Select Sector SPDR-Energy ETF (NYSEARCA:XLE[7])and Select Sector SPDR-Materials ETF (NYSEARCA:XLB[8]) — have both been trading under their 200-days for nearly a month, but XLI has managed to hold up well until this past week. The ETF closed Friday at 34.12, just barely above its 200-day MA at 33.90:

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Two non-equity indicators also are sitting at key levels. First is the 10-year U.S. Treasury note, which has plunged to 1.702% and now sits within a day’s move from its September low of 1.696%. The 30-year paints a similar picture, closing Friday at 2.789% — extremely close to its October low of 2.694%. A drop in Treasury yields is critical because it would signal that confidence remains too low to support a meaningful upturn in equities.

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Second, the CurrencyShares Euro Trust (NYSEARCA:FXE[11]) is in jeopardy of moving to its lowest level since mid-2010. The ETF closed at $127.09 on Friday, a more than a percentage point from its 52-week low of $125.75. This is an important indicator not just for confidence, but for asset classes — such as precious metals — that tend to be hurt by a rising U.S. dollar.

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Three other charts provide an x-ray into the state of investor sentiment. Pay close attention to iShares MSCI Europe Financials Sector Index Fund (NYSEARCA:EUFN[13]), which needs to fall only 4.2% to reach a new low…

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… as well as the iShares MSCI Emerging Markets Index ETF (NYSEARCA:EEM[15]), which moves into a danger zone below $35…

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… and finally, the iShares iBoxx $ InvesTop Investment Grade Corporate Bond Fund (NYSEARCA:LQD[17]). Corporate bonds had been holding up relatively well through the downturn in equities, but LQD’s 1.2% slide last week — in conjunction with the sell-off of more than 3% high yield — indicates that stress has finally begun to take its toll on the credit markets.

With that in mind, watch the trend line that currently terminates at $111.44. LQD still needs to fall 3.5% to reach this trend line, which is a sizable move for the ETF. Still, investors need to keep this on their radar screens since stocks are unlikely to recover as long as credit spreads are rising.

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One final thought: Like the Russell 2000, many of these indicators have fallen to extreme oversold levels, raising the odds of a near-term rebound in higher-risk assets. Nevertheless, it’s essential to keep an eye on these levels to gain an accurate sense of whether any relief rally in stocks is more likely to be a dead-cat bounce than the beginning of a more sustained upturn.